Be Humble About Strategic-Beta Bond ETFs

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Strategic beta ETFs have proliferated in the equity space, but they have tended to be less prominent among fixed-income ETFs. Joining me to discuss that topic is Phillip Yoo. He is an analyst with Morningstar.

Phillip, thank you so much for being here.

Phillip Yoo: Absolutely. Happy to be here.

Benz: Phillip, let's take a look at strategic beta investing in the fixed-income space. Let's start by talking about that Barclays Aggregate Index--what it is and why a lot of observers say that it's a little bit funky and a little bit not representative of the broad U.S. bond market.

Yoo: That is a fair point. Indeed, the index is not as representative as one would like in the fixed-income market. There are several reasons behind it. First of all, the index was not developed as an investing vehicle, but rather developed as a derivatives trading tool by investment banks who were trying to provide services such as swaps.

Second, since the global financial crisis, the U.S. government's tax revenue dropped significantly. Therefore, they had to issue a lot of Treasury bonds in order to finance their operations.

Third, in the fixed-income market there is a presence of noneconomic investors such as pension funds, insurance companies, and central banks whose mandate is not to maximize returns in the fixed-income market but rather, for example, minimizing asset-liability duration mismatch. All these factors have contributed to the current shape of the Bloomberg Barclays Aggregate Index.

Benz: One of the big differentiators relative to, say, active bond managers, active core bond managers, is that the BarCap has a really high weighting in government bonds, right?

Yoo: Absolutely.

Benz: When these ETF providers look at tweaking or doing some sort of strategic beta strategy as it relates to the fixed-income market, what are some of the alterations that they are making, some of the strategies that they are trying to employ?

Yoo: As you pointed out, the Agg Index has heavy emphasis on Treasury bonds. Therefore, investors are taking a lot of duration risk but not enough credit risk which in turn minimize their yield and returns. Given that backdrop a lot of providers are trying to improve their particular profile by reducing the duration risk and taking more credit risk by looking at attributes such as return on invested capital, leverage ratio and yield to worst. In addition, there are some firms trying to apply some factors they have tried in the equity space, for example, low volatility and momentum, and trying to apply them in the fixed-income market space. However, that particular area is still in the early stages given there is not a lot of research has been done so far.

Benz: In your recent article on this topic in Morningstar ETFInvestor, you talked about how the back-tests for some of these strategic beta fixed-income ETFs actually look pretty good, but you also made the great point that we've had this 35-year period of declining interest rates in that what you see when you look at those back-tests may not necessarily hold true going forward.

Yoo: I completely agree with you. I suggest investors take a very humble approach in this by recognizing the fact that there is a risk that future performance will diverge from past performance.

First of all, the future is inherently difficult to predict. Second, as you pointed out, the rates have come down to a point that in some countries they are offering now negative interest rates. The rates have nowhere to go. In other words, the future is highly likely to differ from the past. Finally, there is a tendency that market prices the short-term news more fully than longer-term trends. Therefore, the intrinsic value can diverge substantially from market prices. Investors must be aware of all of these factors and fully embrace them before investing in these products.

Benz: One other question is, when you think of portfolio construction and when you think of an asset that's a really good diversifier for equity exposure, the Barclays Aggregate trackers actually look really good from my standpoint from that perspective as something that's going to help diversify your equity risk. Is that a potential shortfall in some of these strategic beta fixed-income ETFs, that they might not be as good from an equity diversification standpoint?

Yoo: The aggregate index has been a very good diversifier primarily because it has heavy emphasis in Treasury bonds. Treasury bonds are arguably one of the best instruments for downside protection. As these strategic beta fixed-income funds are reducing their exposure to government bonds, investors should not expect the same level of downside protection that they have seen in the Barclays Agg.

Benz: Another point you raised in your article was that the cost issue, that some of these strategic beta bond ETFs do cost more than the other types of fixed-income ETFs. Is that justified?

Yoo: These are typically more expensive because there is an element of active management, particularly around the trading executions. So, these active management features are baked into the cost. However, it is my view that costs will come down as we go far along the curve, primarily because a lot of investors and advisors are still using a lot of tools such as screening funds by fee levels.

Benz: Last question for you is, whether investors should bite on the strategic beta bond ETFs. Is it too early to recommend them or are there any that you like?

Yoo: Before I comment on the timing of it, when investors look at these funds, I would emphasize two points. One is the fee. Just like anything, fees are still the most predictive factor of future returns. And second is the evaluation of economic rationale. They must be transparent and focused on a prudent factor. For example, identifying debt issuers who are creating free cash flow by creating a value to their clients.

Benz: So, should investors look at any of these funds, or do you think they should just pass them by at this point?

Yoo: If any of these funds pass through two tests, the fees and economic rationale, it is certainly worth taking a look at them.

Benz: OK. And I know you and the team will continue to do that. Phillip, thank you so much for being here today.

Yoo: Absolutely. My pleasure.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.